Lecture 37

Review of the Previous
Lecture
• Traditional View of Government Debt
• Ricardian View of Government Debt
• Myopia
• Borrowing Constraints
• Other Perspectives
– Fiscal Policy
– Monetary Policy
Topics under Discussion
• Consumption
– The Consumption Function, APC & MPC
– Consumption Puzzle
– Intertemporal Choice
– Consumer’s Budget Constraints
John Maynard Keynes and the
Consumption Function
The consumption function was central to Keynes’
theory of economic fluctuations presented in The
General Theory in 1936.
• Keynes conjectured that the marginal
propensity to consume-- the amount
consumed out of an additional dollar of income--
is between zero and one. He claimed that the
fundamental law is that out of every dollar of
earned income, people will consume part of it
and save the rest.
John Maynard Keynes and the
Consumption Function
• Keynes also proposed the average propensity
to consume-- the ratio of consumption to
income-- falls as income rises.
• Keynes also held that income is the primary
determinant of consumption and that the interest
rate does not have an important role.
The Consumption Function
C = C + cY
consumption income
spending by depends Marginal
households on Propensity to
consume (MPC)
Autonomous
consumption
C
c Y
+
=C
C
C
Y
The slope of the consumption function is the

MPC.
This consumption function exhibits three
properties that Keynes conjectured.
1.The marginal propensity to consume c is

between zero and one.
2.The average propensity to consume falls as
income rises.
3.Consumption is determined by current
income.
Average Propensity to
Consume
APC = C/Y = C/Y + c
C
As Y rises, C/Y falls,
and so the average
propensity to consume APC1
C/Y falls. Notice that C APC2
the interest rate is not 1
1
included in this Y
function.
Marginal Propensity to
Consume
• To understand the marginal propensity to
consume (MPC), consider a shopping scenario.
–A person who loves to shop probably has a
large MPC, let’s say (.99). This means that for
every extra rupee he or she earns after tax
deductions, he or she spends 99 paisas of it.
• The MPC measures the sensitivity of the change
in one variable (C) with respect to a change in
the other variable (Y).
Secular Stagnation and Simon
Kuznets
• During World War II, on the basis of Keynes’
consumption function, economists predicted that
the economy would experience what they called
secular stagnation, a long depression of infinite
duration-- unless fiscal policy was used to
stimulate aggregate demand.
• It turned out that the end of the war did not throw
the U.S. into another depression, but it did
suggest that Keynes’ conjecture that the
average propensity to consume would fall as
income rose appeared not to hold.
Secular Stagnation and Simon
Kuznets
• Simon Kuznets constructed new aggregate data
on consumption and investment dating back to
1869 and whose work would later earn a Nobel
Prize.
• He discovered that the ratio of consumption to
income was stable over time, despite large
increases in income; again, Keynes’ conjecture
was called into question.
• This brings us to the puzzle…

Consumption Puzzle
• The failure of the secular-stagnation hypothesis
and the findings of
• Kuznets both indicated that the average
propensity to consume is fairly
• constant over time. This presented a puzzle:
why did Keynes’ conjectures hold up well in the
studies of household data and in the studies of
short time-series, but fail when long time series
were examined?
Consumption Puzzle
Studies of household
data and short time-
series found a C Long-run consumption
relationship between function (constant APC)
consumption and
income similar to the
one Keynes Short-run consumption
function (falling APC)
conjectured-- this is
called the short-run
consumption function. Y
But, studies using long time-series found that the APC
did not vary systematically with income--this relationship
is called the long-run consumption function.
Irving Fisher and
Intertemporal Choice
• The economist Irving Fisher developed the
model with which economists analyze how
rational, forward-looking consumers make
intertemporal choices-- that is, choices
involving different periods of time.
• The model illuminates
• the constraints consumers face,
• the preferences they have, and
• how these constraints and preferences
together determine their choices about
consumption and saving.
Irving Fisher and
Intertemporal Choice
When consumers are deciding how much to
consume today versus how much to consume
in the future, they face an intertemporal
budget constraint, which measures the total
resources available for consumption today and in
the future.
Consumer’s Budget
Constraint
• Consider the decision facing a consumer who
lives for two periods (representing youth & age)
• He earns Income Y1, Y2 and consumes C1, C2 in
both periods respectively (adjusted for inflation)
• The savings in the first period will be
S = Y 1 – C1
• In the second period
C2 = (1 + r) S + Y2
where r is the real interest rate.
Consumer’s Budget
Constraint
• Remember S can represent either saving or
borrowing and the equations hold in both cases.
– If C1 < Y1 consumer is saving S>0
– If C1 > Y1 consumer is borrowing S<0
• Assume: r (borrowing) = r (saving)
Combining the two equations:
C2 = (1 + r)(Y1 – C1) + Y2
Rearranging
(1 + r)C1 + C2 = (1 + r)Y1 + Y2
Consumer’s Budget
Constraint
• Dividing both sides by 1 + r
C2 Y2
C1 + = Y1 +
1+r 1+r
Consumer’s Budget
Constraint
• So we can say that
• The consumer’s budget constraint implies
that if the interest rate is zero, the budget
constraint shows that total consumption in
the two periods equals total income in the
two periods. In the usual case in which the
interest rate is greater than zero, future
consumption and future income are
discounted by a factor of 1 + r.
Consumer’s Budget
Constraint
• This discounting arises from the interest
earned on savings. Because the consumer
earns interest on current income that is saved,
future income is worth less than current income.
• Also, because future consumption is paid for out
of savings that have earned interest, future
consumption costs less than current
consumption.
Consumer’s Budget
Constraint
• The factor 1/(1+r) is the price of second-period
consumption measured in terms of first-period
consumption; it is the amount of first-period
consumption that the consumer must forgo to
obtain 1 unit of second-period consumption.
Consumer’s Budget
Constraint
Here are the combinations of first-period and second-period
consumption the consumer can choose.
Second-
If he chooses a point period Consumer’s budget
between A and B, he consumption constraint
consumes less than his B
income in the first period Saving
and saves the rest for the Vertical intercept is
second period. If he (1+r)Y1 + Y2
chooses between A and A Borrowing
C, he consumes more Y2
that his income in the first Horizontal intercept is
C Y1 + Y2/(1+r)
period and borrows to Y1 First-period consumption
make up the difference.
Summary
• Consumption
– The Consumption Function, APC & MPC
– Consumption Puzzle
– Intertemporal Choice
– Consumer’s Budget Constraints
Upcoming Topics
• Consumption
– Consumer Preferences
– Optimization
– Income Effect and Substitution Effect
• Role of Real Interest Rate
– Constraints on Borrowings

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Review of the Previous

The slope of the consumption function is the

1.The marginal propensity to consume c is

• This brings us to the puzzle…

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